Frequently, we are asked by our clients whether it is more beneficial to lease or own their real estate. It is a great question and one that companies should be asking themselves and their advisors, particularly if the new international accounting standards are implemented and leases become “on balance sheet” transactions. The answer, however, is not black and white and will vary based on the company and the type of real estate involved.
Every organization, large and small, will have unique characteristics about its business, its finances, its prospects for the future, and its culture, among other things, that will influence the decision. Two otherwise similar companies can easily come to the opposite conclusions about whether to lease or buy. Here are a few considerations that organizations should explore when evaluating whether to buy or lease their real estate:
1. Capital requirements: For many companies, cash is limited and they must prioritize its use to maximize their overall returns. Buying commercial space typically requires greater up front capital than does leasing. While leasing may require some initial investment to fit-out space (to the extent the cost exceeds the allowance provided by the landlord), it is typically a lot less than the capital required to purchase commercial property. While a company could certainly finance a portion of the acquisition cost in order to preserve capital, this debt could inhibit or limit a company’s ability to borrow for its core operations operations. Finally, the company must consider its required return on capital and whether real estate will achieve that required return. Again, if capital is limited, cash spent on real estate is not available for core business operations. If real estate will generate a higher return than the company’s core business, then maybe the company is in the wrong business.
2. Total cost: In most cases, owning real estate is less expensive over the long term than leasing. That is because with ownership, the purchase price is ultimately paid off and thereafter the company only needs to fund operating expenses, taxes and capital improvements. Over time, the owner builds equity and has an asset that can be monetized. In leasing, however, the tenant never builds equity and pays for its space many times over. While owning real estate may be cheaper over the long term, there is often less predictability year over year with ownership versus leasing. Unexpected capital repairs or replacements may be devastating for an owner who has not reserved for these costs in a given year.
3. Flexibility: Owned real estate is not as flexible as leased space. Whereas leases can be structured for shorter or longer terms with pre-negotiated expansion, contraction or termination rights, ownership limits a company’s options. By way of example, start-up or emerging growth companies might want to avoid owning real estate as their space needs can be uncertain, changing often and quickly. A properly structured lease, however, can allow it to adapt more quickly to changes in headcount. More mature businesses with stable employee population are typically better candidates for ownership as they can properly size their requirement without fear of outgrowing the space or taking on too much. Ultimately, organizations need to secure real estate solutions that will support their business, not dictate it.
4. Commodity vs. Strategic Space: Organizations should consider whether their real estate is unique and strategic or simply generic, commodity space which can be easily and cheaply exited and replicated. Strategic assets often warrant greater ownership consideration than do commodity spaces. Pharmaceutical laboratories, sophisticated manufacturing facilities, data centers, and other infrastructure intensive environments are often considered strategic in nature as they are not easily and inexpensively exited, replaced or replicated. Because the company has so much money invested in the space, it may not, as a practical matter, have the ability to move at the end of its lease term. If it is going to be captive to the space, it may want to consider owning it so it can control its economic destiny and not be at the mercy of the landlord on lease renewals. Facilities can also be strategic if they are located in close proximity to major customers, suppliers, main transportation hubs, ports, rail service, etc. Thus, for example, if a warehouse is across the street from the company’s major supplier, this proximity may be critical to the company’s pricing scheme. Commodity space is typically characterized as being in large supply, not having any extraordinary building features, characteristics or infrastructure, and being cheaply transitioned in and out of i.e. generic office and warehouse space.
Profit and loss statement impacts should also be considered here. If a company has a major investment in space that will not be fully depreciated at the end of its lease term, an exit could result in a material hit to the company’s income statement effectively limiting its options. In such a case, ownership may be a better structure.
5. Balance sheet presentation: Companies should consider if they want their real estate on or off balance sheet. Owned real estate will show up on a company’s financial statements as an asset with corresponding liabilities while a lease will not. On balance sheet treatment may, therefore, negatively impact important financial ratios (for example, return on assets) or even violate loan covenants in a company’s credit facility. On the other hand, companies that use Earnings Before Interest, Taxes, Depreciation and Amortization (EBITA) as their critical financial metric may seek ownership as their real estate costs would mostly fall below the line. Companies should analyze thoroughly what the accounting treatment will be for owning versus leasing real estate and work with their real estate advisor, accountant and lawyer to determine the impact it will have on the bottom line.
Note: The new lease accounting standards proposed by the Fair Accounting Standards Board (FASB)and the International Accounting Standards Board (IASB), which are expected to be approved in the next year or so, may label virtually all real estate leases as “capital leases” thus rendering the “on or off balance sheet” analysis moot for anything other than very short term leases.
6. Convenience: Owning real estate can be labor intensive and subject the company to significant risks. Many companies avoid ownership because unanticipated leaks, broken HVAC systems, and general repair and maintenance issues can not only distract them from their day to day business but also subject them to unexpected capital outlays. Leasing space allows organizations to focus on their core business without the hassle of tending to unexpected facility issues. Further, if the company owns more real estate than it currently needs, it may find it needs to lease the extra space to mitigate the carrying costs. This puts it in the real estate business which creates further risks and distractions.
These considerations, and others, can help inform organizations who are in the market for space in deciding whether to lease or buy. Satisfaction of one or two of these considerations does not necessarily justify leasing over purchasing or vice versa. Only by undertaking a comprehensive financial analysis and examination of what a company’s real estate does to support its business can it make a smart decision about how best to structure its space commitments.
For more information contact Glenn Blumenfeld